What are preference shares?

Most shares issued by companies are ordinary shares, but they are just one of the different types of shares available. Preference shares, sometimes also called ‘preferred shares’ or just ‘prefs’, can also be useful both to investors and the companies issuing them.

In this article we look at the core features of preference shares, additional components that might be attached to them and the advantages and disadvantages of preference shares to both investors and companies looking to raise capital.

Preference shares carry two preferred rights over other classes of shares:

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1 A preferential right to dividends

Dividends on preference shares tend to be at a fixed level set in advance, unlike the variable (or often no) dividend payable on ordinary shares. Usually paid twice a year, preference share dividends must be paid out in full before any dividend can be paid on ordinary shares. However, it’s still possible preference shares will not receive a dividend in any year, as profits must exist from which to pay.

2 A preferential right to repayment of capital

If the company is wound up, preference shareholders are entitled to be repaid their capital contribution before ordinary shareholders receive anything. Like ordinary shares, however, preference shareholders will only be paid once other creditors have been paid in full.

Preference shares generally do not carry voting rights, which may limit their appeal. Usually, they can only vote in specific, extraordinary circumstances – for example, if a proposed change would affect the rights of the preference shareholders or if dividends due on preference shares remain paid.

Preference shares – a mix between ordinary shares and corporate debt

A preference share is sometimes described as a hybrid between an ordinary share and corporate debt, with some features of each.

Preference shares have the following features in common with ordinary shares:

  • They are perpetual shares, with (usually) no requirement for the company to repay the amount invested during its lifetime. It is only on liquidation that a company has an obligation to return capital to shareholders.
  • Like other types of shares, a company allots new shares that may then be transferred from one holder to another.
  • Dividends can only be paid out of distributable profits.
  • Dividends are not deductible as an expense when working out the company’s tax liability.
  • Dividend payment is not obligatory. The directors of the company typically have discretion over whether a dividend should be paid or to reinvest profits into the business.
  • They do not create any charge over the assets of the company.
  • They sit below all secured and unsecured creditors, and only rank for repayment ahead of ordinary shareholders.

At the same time, preference shares have some features in common with corporate debt instruments:

  • They carry a fixed rate of dividend, like the interest payment on corporate debt.
  • They do not carry the right to vote.
  • They rank ahead of ordinary shareholders for return of capital in any liquidation event.

With this combination of features, in principle a preference share will potentially achieve higher rewards but with higher risk than a debt instrument of the same company but lower rewards at lower risk than the company’s ordinary shares.

Features that may apply to preference shares

There are many additional features that can be added, individually or in combination, to preference shares. These may make them more attractive to potential shareholders or the company issuing them. The exact nature and any features of an issue of preference shares should be set out in the company’s articles of association.

Here are the main features you’re likely to find attached to preference shares:

Cumulative preference shares

Just because preference shares rank ahead of ordinary shares in terms of dividend payment doesn’t on its own guarantee they’ll receive a dividend in any particular year. If, because of poor business performance, profits aren’t available to distribute then dividends won’t be paid on either type of shares.

With cumulative preference shares, any amount of ‘missed’ dividend rolls over and accumulates, and must be paid in a later year before any dividend may be paid to ordinary shareholders. So, if a dividend of £1.00 per share is due but cannot be paid in 2017 and 2018, then a £3 dividend must – assuming sufficient profits exist – be paid in 2019 before any dividends on ordinary shares can be declared and paid.

Preference shares are always cumulative, unless it’s expressly stated otherwise in the articles of association.

In comparison, non-cumulative preference shares have the right to a dividend out of the current year’s profits only. If the company fails to pay a dividend in any particular year, often because there are not sufficient profits to do so, the right to the payment is foregone and does not build up as arrears that need to be paid out of future profits.

Participating preference shares

All preference shares bear a fixed dividend, before a dividend is paid on ordinary shares.

If the company meets a certain pre-determined target, usually a profit target meaning ordinary shareholders receive dividends at or above a certain level, then this type of preference shares allow their holders to participate alongside ordinary shareholders in distribution of the surplus. So, in a particularly lucrative year, participating preference shares will pay not only the fixed dividend but also a share of surplus profits, the exact terms of which will be defined in the articles of association.

Some such shares may have an entitlement to share in surplus assets on winding up of the company, which would otherwise benefit only the ordinary shareholders. If this applies, the articles of association will state the ratio in which a surplus of assets should be shared between ordinary and preference shareholders.

In comparison, non-participating preference shares receive only the fixed, standard dividend and no more. They have no right either to participate in any surplus of profits which exists after payment to ordinary shareholders or to participate in any surplus of assets when the company is wound up.

Preference shares are always non-participating, unless it’s expressed otherwise in the articles of association.

Convertible preference shares

Convertible preference shares hold an option – but not an obligation – which allows shareholders to convert their shares into a set number of ordinary shares, at a particular future date or within a specified period. This can be a valuable benefit if the market value of the ordinary shares increases at a time when the preference shareholder can exercise their option.

The conversion right must be stated in the articles of association, which will document the terms that apply and occasionally also give the company directors the right to approve any conversion requested by a shareholder.

In contrast, shares which cannot be converted into ordinary shares are known as non-convertible preference shares. Unless specifically stated in the articles, preference shares are non-convertible.

Redeemable preference shares

With most shares, the capital is only repayable by the company at the time of liquidation. Shareholders cannot demand repayment of the monies invested; nor can the company simply return the share capital without following due process.

With redeemable preference shares, however, the issuing company can choose to buy them back in the future. This will usually be after a defined period has elapsed, on or between certain dates or otherwise at the directors’ discretion after having given notice to shareholders. The exact terms of redemption are documented at the time the shares are issued, usually in the articles of association.

The Companies Act places a number of restrictions on redeemable shares and how capital can be returned to shareholders, which may be supplemented by specific terms in the company’s article of association.

Unless it’s expressly stated otherwise, preference shares cannot be redeemed – they’re ‘irredeemable preference shares’ or ‘perpetual preference shares’.

Adjustable rate preference shares

Rather than a fixed rate, there are a few preference shares in issue where the rate of dividend instead floats, perhaps linked to LIBOR or another prevailing interest rate.

Advantages of preference shares for investors

Compared with ordinary shares:

  1. They provide somewhat more security of income than ordinary shares, because preference share dividends must be paid before a dividend can be declared on ordinary shares.
  2. As the dividend is set at a fixed level, preference shares can be useful for investors looking for a level of certainty of income – compared to ordinary share dividends, which may be more irregular in both frequency and amount. (However, lack of profits may still mean preference dividends are not paid.)
  3. Initial income is likely to be at a higher level than ordinary shares, to compensate for the fact that preference shares do not benefit in the same way from growth in dividends and capital value over time. They may therefore be useful for those to whom a higher income is important.
  4. Additional features, like convertibility and cumulation, can be useful to investors.
  5. Preference shares rank ahead of ordinary shares in terms of return of capital in a liquidation event.
  6. Even though preference shares usually carry no ability to vote on general matters, the holders will typically be able to vote on matters that directly affect their rights.

Compared with corporate bonds:

  1. A preference share should be expected to yield a higher return than a corporate bond issued by the same company.
  2. Income via dividends on shares may be more tax-efficient than the interest received on a corporate bond, with a £2,000 tax-free dividend allowance available and a 7.5% rate of tax on dividends that fall within the basic rate band.

Advantages of preference shares for the issuing company

Compared with ordinary shares:

  1. With features like cumulation and convertibility included, preference shares may be tailored to be attractive to particular people who the company wishes to invest.
  2. Preference shares will not dilute voting rights, which will remain with the existing ordinary shareholders in their existing proportions. That may allow the existing owners to retain control over the company, which might be lost if further ordinary shares were issued instead.

Compared with corporate bonds:

  1. There is no obligation to pay dividends if there are no profits, unlike the payment of interest on corporate debt.
  2. Preference shares can provide longer-term capital, with no fixed date at which it must be repaid.
  3. Preference shares do not require assets to be pledged as security, either on a secured or unsecured basis. That also leaves any mortgageable assets available to be used as charges on loans in the future.
  4. With the different features that can be incorporated into preference shares, there is significant flexibility to establish terms that best suit the current needs of the company and will attract the right investors.

Disadvantages of preference shares for investors

Compared with ordinary shares:

  1. All other things being equal, because they face lower risk of non-payment of dividends and capital, investors should expect lower returns from preference shares compared to ordinary share capital.
  2. Unlike ordinary shares, preference shares with a fixed dividend (except if they are participating preference shares) will not share in a higher dividend during times when the business is succeeding.
  3. If dividends on preference shares are fixed in monetary terms, inflation will reduce the real value of the dividends received over time. Typically, ordinary shares will get the benefit of growth in dividends (and capital value) over time, often keeping pace with or exceeding inflation.
  4. With no voting rights, the holders of preference shares have very little say over the running of the company.
  5. There is a smaller market for preference shares than ordinary shares, so they may be harder to buy and sell. Anyone in a rush to sell, particularly the sale of a large number of shares, may have to accept a lower price.

Compared with corporate bonds:

  1. If the company has insufficient profits in a year then any entitlement to a dividend payment is lost (unless it rolls over, in the case of cumulative preference shares). Interest payments on corporate debt must still be paid whether or not the company has made a profit.
  2. Everything else being equal, because they face higher risk of non-payment of income and capital, investors should expect higher returns on preference shares than a corporate bond of the same capital.
  3. Preference shareholders no not enjoy any charge over assets of the company, which usually benefits holder of debentures.
  4. Even if the loan is unsecured, holders of corporate debt rank ahead of preference shareholders on repayment of capital in any liquidation event. As preference shareholders usually rank behind all creditors other than the ordinary shareholders, it’s very possible they’ll receive no repayment of capital.
  5. The market price of preference shares tends to fluctuate far more than that of debentures.

Disadvantages of preference shares for the issuing company

Compared with ordinary shares:

  1. If a second (or further) class of share is created to support preference shares, it adds extra complexity to managing the company’s share capital. Initially, the company’s articles of association are likely to require updating, and from that point on it’ll be necessary to study the respective rights of different share classes when there are profits to distribute or decisions to be made by shareholders. This complexity will be exacerbated if the preference shares have tailored rights.
  2. There may be hostility from some existing ordinary shareholders, if the additional rights that apply to preference shares are seen as unfair. Particularly if some of those ordinary shareholders are also involved in management of the business, it has the potential to create tension and conflict.
  3. A combination of these factors may also make shares in the company, whether preferred or ordinary, less attractive to those investors who want a clear view of their stake in the company and how their rights relate to those of other shareholders. This may make it tougher for the company to raise capital by issuing shares.

Compared with corporate bonds:

  1. The cost for the company of raising capital via preference shares will generally be higher than issuing debt securities. That’s because investors expect a higher rate of dividend to compensate for the higher risk attached to shares compared with debt securities.
  2. A preference share dividend is not a deductible expense for the company, unlike interest on a debenture or other corporate debt. Therefore, there is a tax disadvantage for the company.
  3. Cumulative preference shares, unless they are redeemable, become a permanent burden for the company. In terms of dividends, their preferential rights can be restrictive where there is a particular desire to make a dividend distribution to the company’s ordinary shareholders.

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Article Comments

  1. Richard Gray says:

    I cannot thank you enough for this overview. It is enlightening and concise. Really well written -thanks again

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